Originally published in the Financial Times:
Chrystia Freeland, US managing editor, interviewed Julie Dickson, superindendent of financial institutions for Canada about regulation, the Canadian banking model and the resilience of Canadian banks in the financial crisis. This is a transcript of that interview.
PART 1: On the resilience of Canadian banks in the financial crisis
FT: Thank you for joining us, Ms Dickson. Why do you think Canadian banks have proven so resilient in this global financial crisis?
JD: As the regulator I can talk a bit about the role that regulation played. I do think that Canadian banks themselves were prudently managed so they deserve some credit for that, but on the regulatory side we point to a couple of key things. First: capital. We had tier one target of 7 per cent going back to 1999.
FT: And at that moment the Basel target was ... ?
JD: Four per cent. We also paid attention to the quality of capital, so 75 per cent of that tier one had to be in common shares. That was very important. Leverage ratio was very important, we think. Not only to keep as a backstop to risk-based capital, but also as a supervisory measure.
FT: And the leverage ratio was 20 to one?
JD: Yes. With approval you can go to 23 but most of our banks are around 16 to 18 times. The quality of supervision is something that I think can be overlooked. In Canada we’ve spent a lot of time focusing on staff at Osfi and trying to get that mix of private-sector people and lifetime regulators. We’ve got a mandate that I think is very good, a legislative mandate which required us to focus on solvency and early intervention. That was extremely important, and I might say the country Canada was not afraid to be subject to an FSAP process, Financial Stability Assessment Program. We’ve been looked at twice now, most recently in 2007. I think you have to open yourself to those kinds of external exams to see whether you are doing what you should be doing.
FT: Do you rate those FSAP examiners? Do you think they did a good job?
JD: I think that they came up with some recommendations that were useful and we did adopt them. Going back to the first FSAP, they noticed that we needed an extra power, the power to remove directors and officers, so the government promptly changed that. More recently in 2007 they suggested that we needed some more resources, that we were too reliant on the financial institution senior management and boards, so we have added staff since then. I think that having an international group come in and look at your processes is really quite key to be sure that you’re on the right track.
FT: Some of the rules that you’ve mentioned; the capital requirement, the quality of capital, the leverage ratios, these were much tougher in Canada than they were in other parts of the world. Wasn’t there any resistance to that, especially during the go-go years when other banks were able to expand more, were able to do more and the poor Canadian banks were labouring under these tougher rules?
JD: I think at the get-go when the 7 per cent tier one target was introduced there was a lot of resistance but what I’ve found over the years was that that faded away, and in fact Canadian banks were way above those targets. If you look at the third quarter of 2008 when things really got difficult in the financial sector they were 9.5 to almost 10 per cent tier one. Why was that? I think that that is a tribute not only to Canadian banks and their prudence, but we spent a lot of time on what we call the internal capital adequacy assessment process which was part of Basel II, so we spent a lot of time with banks trying to ensure that they themselves were looking at the capital that they needed for the risk that they had. I don’t recall a lot of pushback when it came to capital requirements in the years leading up to the crisis. On the leverage ratio, no one was very happy with the leverage ratio all along, and when Basel II was being developed we heard a lot about the need to get rid of the leverage ratio. You’re going to a risk-based capital regime you need to get rid of the leverage ratio. At that time we said let’s just see how Basel II unfolds, let’s just see how this all works out. What we’ve now learned is that that was a very important backstop and it’s also a prime supervisory tool, so if we find an institution where we have identified some issues and we don’t think they’re fixing it fast enough, if you reduce the leverage ratio you get an immediate reaction and all eyes are focused on fixing the problem.
FT: If you as the supervisor come in and say I’m reducing your leverage ratio?
JD: Yes. What that does too is it caps the growth while you’re trying to sort out the problem that you’ve identified, so I think it’s a very important tool both from a capital perspective and it’s a useful thing to have in your toolbox.
FT: Some of these protests around the idea of the leverage ratio, what were people saying? Were they saying this is limiting the ability of our banks to compete internationally, this is limiting access to credit in our country and therefore economic growth? What were the arguments?
JD: Usually competition is noted and if you look around the world and don’t see a leverage ratio in many places, that is a big point. Although they did know there was a leverage ratio in the United States and that is a big competitor.
FT: And you have the unilateral authority to cut the leverage ratio?
JD: Yes, and I think that’s another key ingredient as to why we’ve had some success in Canada. We have a lot of freedom to act. That needs to be talked about internationally. People are so focused on the rules. What should tier one be? What should the leverage ratio be? That’s only part of it. You can have all the capital in the world but if you don’t have a supervisor who has the independence and the authority to act quickly, then you have a system that I think is prone to risk-taking and a build-up of excesses.
FT: Would you say that the leverage ratio is your most powerful way of getting a bank’s attention?
JD: I think it is a powerful way. Is it the most powerful way? I think that it is extremely powerful, yes.
FT: How close is your relationship with the board? How often would you attend a board meeting of a regular bank?
JD: If we’re talking the major banks, a minimum of once a year.
FT: You personally?
JD: Yes. Sometimes we will do it twice a year. Some boards want more interaction with the supervisor so they like to have a meeting halfway through the year just to see how things are going, but the annual meeting which takes place generally every January is to discuss our findings from a year’s worth of supervisory work. If you have an institution that is staged or that has problems they might see the supervisor more.
FT: How do you find the bank management, the independent directors, respond to you during those meetings? Do they pay attention? Is it a sense of being given a report card or are they pushing back more?
JD: It depends. I’ve seen both, I’ve seen boards that immediately spring to action and are very concerned that the supervisor has an issue. I’ve also seen boards that push back and side with the CEO, so it really depends on the situation and the problem that has been identified. It’s far easier when it’s clear. There have been big issues. It’s clear. Everyone agrees. Where it is very difficult is when you have identified a problem very early, before any losses occur, before any other regulators say anything around the world. If you are in there early then you really get the pushback, but that’s an effective system you’re in early.
FT: What kind of moments do you recall where you’ve been in early?
JD: Lots of moments, but a good example would be where you just see red flags. You might have done some kind of in depth drill-down and you just see some red flags, either with controls, controls have lagged the growth in the business but there’ve been no problems, but the controls have lagged the growth in the business. Say management is pursuing a bit of a new strategy without informing the board, no losses, everything is fine, but it’s not good to have a new strategy and not to have informed the board. Those are a few examples.
PART II: On her approach to regulation
FT: How would you describe your philosophy of regulation? Is it more rules-based or more principles-based?
JD: Most often it’s described as principles-based. This is an interesting discussion. By principle we’re saying we want an effective system here. We want the industry to communicate with us. We want to be told everything that is going on. We want to all use our brains. We don’t want to have a list of boxes that we tick because that’s not very effective. We do have a lot of rules. The leverage ratio is a rule. Tier one 7 per cent is a rule.
FT: Quality of capital.
JD: Yes. We have some rules, and I think those rules served us well, but you need a lot of interaction between the regulator and the institution because they’re out there operating day to day. They know what their competitors are doing. They know what foreign regulators are doing sometimes even before we do, so you do need that interaction. I really stress that communication.
FT: Some people would describe the relationship between the US banks and their regulators as a fairly legalistic one where there is an effort to try to engage lawyers and maybe accountants in complying with the rules at the least possible cost. Do you think that’s what happens in Canada?
JD: It’s not what happens in Canada. Sometimes I do see it, though. I think that there’s an appreciation in the industry for the fact that we don’t work that way. Having lawyers looking at this line or that clause and debating with you about whether something is doable or not is not the right conversation to have. The right conversation to have is the principle. You have to have adequate capital liquidity. You have to know the risks you’re undertaking. You have to manage those risks. That’s what you really should be talking about, not about what this word says or that word says. On occasion I do find that seeping in, but usually that’s with an institution that perhaps has a US owner as opposed to a financial institution.
FT: Really? You can see that national difference?
JD: You can see it, yes.
FT: Why is that the wrong approach?
JD: I don’t know that I’d say it’s the wrong approach. I’m used to a system where I can pick up the phone and make half a dozen phone calls and see some change.
FT: Really? That’s all it takes? Six phone calls a day changes behaviour?
JD: We have a small system in Canada, you can get your arms around it, and I think both sides value the relationship that we have as a result. We have a lot of powers at Osfi. We have a lot of tools in the toolbox. I think people are aware of that, so I don’t think they want to get to the point where we actually have to start using those tools. I’m not saying we’re always right either. I can have a discussion with a CEO and my colleagues as well, and we can be persuaded, but I would say that for the most part we’ve done a few things right, I think, in terms of seeing some risks and trying to have them dealt with. We’re not perfect, but I think for the most part our record has been good.
FT: The one moment in the financial crisis where things were tougher in Canada than for everybody else was with the commercial paper market. Some people have described that to me as a wake-up call, and as something that prepared them better for what was to come. Did you feel that way?
JD: I don’t know. I think it’s a bit late to get the wake-up call. I mean, that was August 2007, so maybe that gave people three quarters to prepare for the third quarter of 2008. It’s always nice to be prepared before then. I think really what matters is what you’ve done in that long period of time before the crisis. What were your capital requirements? What kind of supervisory system were you running? It’s a bit late if you have to start preparing three quarters ahead of a major problem.
FT: With hindsight, do you think that the commercial paper was not ideally structured and that the get-out clause that the banks found they had maybe was good for individual institutions but lead to more systemic instability?
JD: I think that what we saw in Canada was an unregulated sector that grew in leaps and bounds and securitisation vehicles without adequate access to liquidity. That was an issue and something that I think we’ve all learned from.
FT: Are you an advocate of a clearing system for the trading of credit derivatives?
JD: I think everyone sees a lot of merit in that, so the challenge is to try to ensure that that central counter party, or whatever it is ultimately, is very sound and very well put together, but that does eliminate a lot of the risk that we saw in the lead-up to this crisis, yes.
FT: You’ve talked about the relatively small size of the Canadian banking sector as being an advantage to you. Does it make it easier that the market is dominated by five or six banks?
JD: Yes, I’m fairly confident that being able to pick up the phone and making a few phone calls and taking action early is very important and being able to pick up the phone and reach 90 per cent of the system in a couple of hours I think is a competitive advantage, let’s say.
FT: Don’t you worry about the flipside, that having your market dominated by such big institutions means that if one were to fail things would be a lot more devastating?
JD: I think that is one of the biggest issues that people need to focus on. It’s interesting when you talk about size, in terms of competition policy we all know that if you’re so big that you’re substantially impeding competition the solution is to break you up, but size as it relates to prudential issues is far more difficult. I recall about nine months ago asking for all the literature on why size is important from a global economic development perspective and I was quite surprised to see how little came back. There is not a lot of research on this, and I think we’ve got to look at that.
FT: You mean the case hasn’t been made?
JD: Not in the literature, that size is really important for global economic growth. I do see everyone talking about that and making that assertion, but I haven’t seen it in the literature. One of the things that we’re doing now is looking at assessing the need for a capital surcharge on these big institutions, and that will be interesting work because the idea there is that they’ve got externalities, so when they fail there are social costs imposed, so it’s like a polluter or traffic congestion and if you’re a polluter or if you’re in London and you’ve got traffic congestion the solution is to tax, but in this case it’s a moving target – what is systemically important? We haven’t sorted that out yet. We’re talking about indicators like size and substitute ability and interconnectedness, but everyone is also saying that it really depends on the circumstances. Imposing a tax to deal with externalities is going to be incredibly challenging and related to that would be the idea that you might have to identify institutions as systemically important, which I think would be a very bad idea. That seems to me to be a licence to take risk.
FT: It would make explicit the government guarantee.
JD: Yes, so you have an incentive to take more risks. People who are lending to you have no incentive to follow what you’re doing, so what we’ve been promoting internationally is the idea of contingent capital. The idea would be that you restore some of the market discipline by restoring tension between bondholders and shareholders and by making it clear that what we’re suggesting is that it triggers that if governments ever have to support an institution, that before they can do that, subordinated debt must convert into tier one. That way you’ve doled out penalties, you’ve diluted or wiped out the common shareholders, the debtholders pay the price.
FT: Would you apply your contingent capital solution after the fact as it were, because it’s one thing to talk about it in Canada where the government haven’t had to bail out institutions? What do you do in countries where the institutions have been bailed out and already enjoy that now explicit government guarantee?
JD: But this would be going forward, so this would be around the world. The G7 issued a press release on Thanksgiving 2008 I guess, where they all indicated they would support the financial system, so that’s been done. So we all have to look at what you do going forward. How do you restore market discipline? You can not rely on regulators. Some regulators have had more success than others, but regulatory agencies are small, relative to the institutions that they are overseeing. You’ve got to have other mechanisms and you’ve got to have market discipline. If you don’t have that I think that you have not learned much from this crisis. We really do need to focus on that.
PART III: On the Canadian banking model
FT: What’s your view on the debate right now about narrow banking versus universal banking? A lot of people are blaming the existence of big universal banks for the crisis.
JD: In Canada the model worked. Why did it work? Maybe because the prudential supervisor saw the whole thing so banks owned the major investment dealers. That meant the leverage ratio applied. It meant that the kinds of risk management that we expected in banks also applied in the investment banks, so we had a model that worked here. I’m watching with interest that international debate. I think I would agree with some of the points that Adair Turner of the FSA has made. He’s talked about the fact that we’re increasing trading-book capital two to three times through Basel. We’re also looking at the whole trading book, the capital requirements in general going forward for the trading book, even beyond that. That’s going to have some impact on your appetite for expanding the capital markets business. I think he’s also pointed out that true narrow bank proponents want the narrow bank regulated and everything else outside. I think we saw in this crisis that it might not be a good idea to have an unregulated sector, so to speak, thriving alongside of a narrow banking sector, so I think I would be more inclined to agree with Adair Turner on that.
FT: What constitutes strong risk management? When you look at a bank, what makes you say yes, this is going to work?
JD: It can be a lot of things. First you have to have some management information systems that give you the information that is needed, so that’s going back, that’s trying to look forward, so stress testing is a very good example of the kinds of things that people need to be doing and doing in a much more robust fashion. Independence. You need chief risk officers who are independent and can do their job and have clout, who get paid properly.
FT: What does that mean? Do they have to be paid as much as the star traders?
JD: That’s a really good question. Do they have to be paid as much as the star traders? I don’t think that anyone has the answer to that. We certainly know that we can’t pay them a pittance and pay the business people a fortune. That doesn’t quite work. I think you need to start looking at a balance scorecard. If a bank is staged you wouldn’t want to be paying your chief risk officer a huge bonus, I don’t think. There are a lot of things that have to be thought about, and even aside from compensation. others point to things like prestige. Who takes you out to lunch as the chief risk officer? All kinds of little subtle things like that which can drive your actions even more than what you’re ultimately paid. I think what we’ll learn in the crisis is that supervisors need to spend a lot more time thinking about that. What makes people tick? What are the incentives that drive their behaviours?
FT: Are internal reporting lines important to you? Does the chief risk officer have to report to the CEO?
JD: They’ve become much more important. A number of Canadian banks have made a change in that regard because various international reports came out and said that this was important. But again, you need to use judgement. Just because the chief risk officer reports to the CEO doesn’t mean that it’s working well.
FT: Compensation in the financial services has been a hot issue in many places around the world. Is that something you’re concerned about?
JD: We are implementing the financial stability board principles and recommendations that were endorsed by the G20. We’re spending a lot of time on that. I think all regulators would agree, and the industry agreed, frankly, in the Institute of International Finance report, that compensation was a factor, and the failure of most institutions to adjust for risk was a shortcoming in governance and in the way that they ran institutions, so we are paying attention to it.
FT: Don’t you have Canadian bankers say, ‘Come on, we were okay. Why should we be limited? We didn’t make the mistakes everybody else did.’
JD: They’re not really saying that. They are saying I’m glad - maybe they’re just saying this for me. They’re saying they too need to learn the lessons even though they perform well. There are some lessons to be learned, and that is one of them. They don’t really have a choice either because we are implementing the principles. I think we’re trying to be sensible about it though. I don’t think that this is something where you look at what they’ve done this year and you say you’ve done that, we will turn our attention away and look at some other things now. This should evolve because adjusting for risk is new and I don’t think that there is a cookbook that tells you how to do it and you’re sure that you have it right, so I see it evolving over time. I think it’s an area that we will pay attention to over time and as you know, there’s a lot of continuing discussion about that internationally.
FT: With Canadian banks in particular, is there any danger that now will be a sort of Icarus moment? That having done well in the crisis, having gone way up in international league tables, this will be the moment in which they will make some crazy acquisitions or do something else equally unwise?
JD: I think there’s always the risk – what is the saying – you learn more from your mistakes than from your successes. I think we all need to keep that in mind. I certainly talk about that at Osfi too. I think that everyone at Osfi should continue to pay close attention to the risk and not assume that we’re very good identifying them all because it’s constantly changing. For financial institutions, they need to bear down on risk and not assume that they are smarter than anybody else.
FT: What level of capital requirement are you in favour of?
JD: We haven’t talked about that yet at Basel. What I’ve said in some of the speeches that I’ve done is that, if I look back we had it about right in Canada, so we had a 7 per cent tier one requirement going into ... at the worst part of the crisis banks were at 9.15, 9.19, something like that in terms of tier one, common shares at 8 per cent. Those are nice levels. We had enough capital that banks maintained the confidence of the marketplace and they were able to raise more, so now they’re way above even those levels, so what I’ve said is I don’t think you should have enough capital to get you through every tail event that we could ever possibly see. That would impose too many costs on the banking system, but you have to have enough to maintain market confidence in you when you face a severe event, so I would say we had it about right, and that would be what I would be suggesting internationally.
PART IV: On Canadian culture and Osfi
FT: Has the Canadian economy paid a price for its relative conservatism in terms of credit less available, less financial innovation, maybe less economic innovation?
JD: I would say that Canadian banks entered this with a lot of strength behind them, so they were well situated to continue to lend, so we haven’t seen the kind of credit crunch I know that other countries have been concerned about, so I’d like to say that good regulation and supervision is a competitive advantage. It may not seem like it when everyone is at the party, but it certainly is the case when the party is over, so I see it as more of a competitive advantage and on the innovation side I’ve been saying I don’t really talk up innovation, I don’t talk it down either. I talk about risk management around it.
FT: Some people have attributed the relative resilience of the Canadian banking sector to Canadian culture. Do you think that’s fair, or is it more about institutions and rules?
JD: That gets into psychology and that sort of thing which is not my forte, but it probably played a role. My sense is that Canadians in general tend to be a bit more conservative and prudent, so that could be.
FT: How about gender? There have been some studies, particularly in the wake of the crisis, talking about how maybe women tend to be more risk averse, more prudent. Do you think that’s played a role?
JD: I don’t know. If you look at a lot of the policies we had, they’ve gone back a long way, and it was men who introduced some of those policies, so I don’t usually spend a lot of time thinking about that. We’re one team at Osfi and I don’t actually see a different view coming from women versus men. We all seem to be singing from the same hymn book and perhaps that reflects our mandate, which I think is very important, and our focus on risk. I don’t know, good question, but ...
FT: You’ve been described as a reserved person. In fact a magazine article about you this year didn’t have your picture. It just had the crown of your head on it, but you also call up the CEOs of banks and tell them what they have to do. Is that ever hard for you?
JD: I enjoy that. Part of the reason why I didn’t want my picture on the front page was because it’s an Osfi effort, and as I said earlier, a lot of the things that Osfi did were things we did in the good times and there are a lot of people at Osfi who deserve credit for what was done, and that is very important. It’s a team effort, and I don’t think that I should be singled out for all the credit. I think this was truly a team effort. All Osfi employees, present and past, participated in that.
FT: What’s the risk you’re most worried about now?
JD: I don’t think that I would say this one particular risk. I think that it’s the range of risks that I talked about. Exit strategy. Timing. Low interest rates for a sustained period of time, what does that mean? Is the deleveraging process not even halfway finished, is the stock market overvalued, will these global imbalances that created the problem ultimately be resolved. On the regulatory side I see a lot of risks. The idea of identifying an institution as systemic I think is a very bad idea. I would not like to see that happen. I think that would be a recipe for enhanced risk-taking. Those are the things that are on my mind.
FT: Thank you very much.
JD: Thank you.
FT: Now we are going to play long/short, Ms Dickson. Are you ready?
FT: US dollar. Are you long or short?
JD: Well, I don’t have any money to invest, so I’m neither.
FT: Canadian dollar.
JD: No money to invest, so I’m neither.
JD: No money to invest, so I’m neither.
JD: No money to invest.
JD: You have to ask private-sector people those questions because as a regulator we’re not permitted to invest in financial institution stocks but we don’t have money to go investing in, or shorting US dollars, or whatever.
FT: I guess we’re going to have to give you a break on long/short.
JD: Yes you are.
FT: Thank you very much.
JD: Thank you.